Ronald Coase and Comparative Institutional Analysis

|Peter Boettke|

Ronald Coase passed away yesterday at the age of 102. Coase was a productive (and feisty, though always gentlemanly) scholar to the end. In 2012, he published How China Became Capitalist and did a podcast with Russ Roberts for EconTalk on his life, career, and the new book.

As readers here will no doubt know, Coase became a famous economic thinker based on his "Nature of the Firm" (1937) and "The Problem of Social Cost" (1960). While many younger readers will associate Coase with the University of Chicago and what they understand the field of Law and Economics to be, Ronald Coase didn't join the staff at the University of Chicago Law School until 1964. His formative intellectual background was at the London School of Economics in the 1930s, where Hayek loomed as a large intellectual influence (along with Robbins and Arnold Plant). The ideas behind Coase's examination of the nature of the firm, he told us on numerous ocassions, were born in contemplation of Plants discussion of the socialist calculation controversy and his everyday observations of the organization of business activities during his study trip to the US. As he began teaching, he had to present a lecture on the firm and these ideas clicked.

The Coase theorem as laid out in "The Problem of Social Cost" emerged out of his studying of broadcasting rights and the FCC, and it was written and published while Coase was at the University of Virginia, working alongside of James Buchanan and Warren Nutter at the Thomas Jefferson Center for Studies in Political Economy. "The Thomas Jefferson Center", James Buchanan wrote in 1958, "strives to carry on the honorable tradition of 'political economy' -- the study of what makes for a 'good society.' Political economists stress the technical economic principles that one must understand in order to assess alternative arrangements for promoting peaceful cooperation and productive specialization among free men." It is this second sentence that I want to emphasize today because Coase's analysis is only properly understood within that context.

As Deirdre McCloskey has famously said: "Something like a dozen people in the world understand that the 'Coase Theorem' is not the Coase Theorem. (I'll adopt the convention of putting quotation marks around the non-Coasean 'Coase Theorem'.) One of this select group is Ronald Coase himself, so I suspect we blessed few are right." My good friend Steve Medema has written most extensively about the substantive content of the Coase theorem, and the professional sociology around the 'Coase Theorem'. See here and here for recent statements by Steve. On things Coase, I would trust Steve more than any other source.

The point of Coase's intellectual exercise was to get economists (and others) to think not of the zero-transaction cost world, but instead about the role that alternative institutions play in ameliorating or exacerbating conflicts in a world of positive transaction costs. It is all about comparative institutional analysis.

One of my favorite passages from Coase actually comes from the FCC paper, where he states:

This "novel theory" (novel with Adam Smith) is, of course, that the allocation of resources should be determined by the forces of the market rather than a result of government decisions. Quite apart from the misallocations which are the result of political pressures, an administrative agency which attempts to perform this function normally carried out by the pricing mechanism operates under two handicaps. First of all, it lacks the precise monetary measure of benefit and cost provides by the market. Second, it cannot, by the nature of things, be in possession of all the relevant information possessed by the managers of every business which uses or might use radio frequencies, to say nothing of the preferences of consumers for the various goods and services in the production of which radio frequencies could be used." (1959, 18)

In my reading, what Coase does in this short passage is lay the ground work for robust political economy by combining the insights from Smith and Hume, Mises and Hayek, and Buchanan and Tullock. Or, as Coase wrote in the closing paragraph of "The Problem of Social Cost":

in choosing between social arrangements within the context of which individual decisions are made, we have to bear in mind that a change in the existing system which will lead to an improvement in some decisions may well lead to a worsening of others. Furthermore we have to take into account the costs involved in operating the various social arrangements (whether it be the working of a market or of a government department) as well as the costs involved in moving to a new system. In devising and choosing between social arrangements we should have regard for the total effect. This, above all, is the change in approach which I am advocating.

Ronald Coase was a masterful economist. His work represents the approach to political economy that was pioneered at LSE and developed into the Virginia School of Political Economy. He was a champion of basic economic reasoning pursued persistently and consistently, and for an appreciation of real-world institutional diversity and its implications. His work inspired economists throughout the world. The textbook which I am affiliated with -- The Economic Way of Thinking -- now in its 13th edition, was a by-product of the Coasean influence at the University of Washington, where Paul Heyne taught, and where research on Coasean bargins emerged in the writings of Steven Cheung, Yoram Barzel, Robert Higgs, and Douglass North and in a variety of historical/institutional settings. This influence (along with the UCLA, Virginia, and Austrian influences) still leave a significant mark on the presentation.

When I taught a comparative institutional analysis course at NYU I used to make my graduate students read Coase's papers repeatedly. The average student in that class was more interested in mechanism design theory than the sort of institutional economics I was peddling. I have my own take on mechanism design theory (see my WSJ article on the 2007 Nobel), but I would nudge those students by refering to Coase as the ideal "economic minimalist" to be contrasted with the "economic maximalist". The economic minimalist strives to have the greatest insight with the least theory possible, while the maximalist has very little insight for a lot of theoretical mumbo-jumbo. As many of you are probably doing now, the students didn't always "get" what I was trying to say, but I persisted. Most practicing economist don't see the power of basic economic reasoning or are in awe of the mystery of the mundane experience of everyday commercial activity, so enamoured they are with technique and so-called sophisticated efforts at measurement. In one debate, William Baumol got confused on basic economic principles and Coase responded: "In my youth it was said that what was too silly to be said may be sung. In modern economics is may be put into mathematics." (The Firm, The Market and The Law [1988] 185) Unfortunately, this is a problem that persists in contemporary economics. In fact, I would argue that an entire generation of economists have been led down the wrong path by the way microeconomic theory is taught in graduate schools these days. (See the blog Reading Mas-Colell, which while from a very different perspective than me, raises very important questions about the problems with the approach)

With respect to empirical research in political economy, Coase in his openning address to ISNIE back in 1999 wrote: " Economics, over the years, has become more and more abstract and divorced from events in the real world. Economists, by and large, do not study the workings of the actual economic system. They theorize about it. As Ely Devons, an English economist, once said at a meeting, "If economists wished to study the horse, they wouldn’t go and look at horses. They’d sit in their studies and say to themselves, ‘What would I do if I were a horse?’" And they would soon discover that they would maximize their utilities."

Coase was a champion of basic economic reasoning but detailed institutional analysis. He appreciated the "invisible hand" of the market, but understood that the operation of economics forces at work where always within the context of specific institutions. His was a quest for, as his Virginia School colleague Buchanan put it, "a genuine institutional economics." (see Buchanan, The Demand and Supply of Public Goods [1968] 5) To accomplish this, Coase believed the detailed knowledge of real-world institutions had to be unearthed and examined by social scientists, and he had great hope that New Institutional Economics would provide the foundation for this work. As he put it in the ISNIE address I linked to above: "we know that the costs of exchange depend on the institutions of a country — the legal system (property rights and their enforcement), the political system, the educational system, the culture. These institutions in effect govern the performance of the economic system. This is the basic reason why the New Institutional Economics is so important and why, if we are to achieve our objective, we have to enlist the help of lawyers, political scientists, sociologists, anthropologists and other social scientists. This, of course, is what we are going to do in our Society. The entry of economic analysis into the other social sciences has been termed economic imperialism. We are engaged in a completely different enterprise — enlisting the help of those in the other social sciences to enable us to understand better how the economic system works."

Comments

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In the linked interview, Coase stated that he was in disagreement with some of the work of Buchanan and Tullock in Public Choice. What aspects of New Institutional economics might be in tension with Buchanan-style public choice? I would be interested in some explanation about the points of possible disagreement.

The economic minimalist strives to have the greatest insight with the least theory possible, while the maximalist has very little insight for a lot of theoretical mumbo-jumbo.

This is a great point that should probably be emphasized in its own blog post (unless it already has, and I've missed it). A "simple" understanding of basic economic law reveals a lot about the real world, and many an economist either lacks or ignores such understanding.

It reminds me of Lerner's "Boulevard of Broken Dreams," a book I've recently had the opportunity to read in order to review a Swedish translation, in which the author argues that entrepreneurship in many countries is dependent on government support. According to the book, many government programs for entrepreneurship fail, but it is because they do the wrong things - and, consequently, we can get more out of these expensive programs if we use economic research to make them "better."

I've been through the whole book, but there is not a single mention of opportunity cost of such government investments, not a single reference to that which is not seen. I find it shocking that economists make such blatant errors and argue in a scientific-sounding way for what can best be described as central planning - without even considering alternatives.

The basic assumption for Lerner, his starting point, is that we need "more" entrepreneurship and that it cannot happen without government support. But what about government-created obstacles to entrepreneurship? What about consumer wants and producing real value? No mention of those. They are obviously unimportant in modern "analysis." Scary.

This is a fine tribute to a great thinker. Although as a student at U.Va. law school I heard a lot more about the Coase Theorem than I cared for at the time, I'm pleased to have had the privilege to learn from people under the unfluence of so fine a scholar.